Lower than expected production brings sigh of relief for shale drillers

An Iranian oil worker rides his bicycle at the Tehran's oil refinery south of the capital Tehran. Iran put out an additional 220,000 barrels a day last month, not enough
to overwhelm the overseas market.

A widely anticipated flood of Iranian oil still hasn't arrived two months after the end of the West's oil sanctions, and U.S. shale drillers are breathing a sigh of relief as it appears this year's biggest threat to the industry has fizzled.

In its first big test, Iran put out an additional 220,000 barrels a day last month, not enough to overwhelm the overseas markets that had expected more than twice that amount. Iran was the No. 2 oil-producer within OPEC nation after Saudi Arabia just three years ago, but now it looks like it will make a slow return.

"This is supposed to be the boom time for them," said Jamie Webster, an oil-market analyst at research firm IHS in Washington, D.C. "The first two months are when you're going to see the vast bulk of it. They've had time to prepare. They've probably done as much as they can."

The U.S. oil industry, with its network of companies and advisers in Houston, has sacrificed thousands of jobs and scores of firms and is expected to give up half a million barrels a day in service of an oil market that's in the middle of absorbing a big oil surplus. An oil-production surge from Iran is one of the few things that could have severely derailed that ongoing natural correction, which is expected to bring the world's crude production and global demand back into balance in late 2016 or in early 2017.

U.S. crude on Friday climbed to $38.50 a barrel, its highest point in three months, after the International Energy Agency reported on Iran's February production increase and said its return to the market "has been less dramatic than the Iranians said it would be."

Setting production caps

Iran's lower-than-expected production increase is one reason crude prices have climbed in recent weeks, but it could also have an odd - and potentially negative - impact on the oil market in coming weeks. OPEC nations and rival oil-production countries like Russia are expected to meet to later this month to decide whether to cap their production levels, and the IEA believes the negotiators want to push prices up to $50 a barrel.

More than a month of hints from oil ministers about the so-called freeze - and speculation that it could lead to a production cut - has boosted oil prices. It has given speculators the impression that opening a dialogue could lead to more constructive actions like easing production. But one reason it has taken so long to arrange a meeting is that Saudi Arabia and other OPEC nations likely wanted to see how Iran would perform when it returned to the market.

Now that Iran's crude production has come in lower than expected, it could relieve some pressure from the oil exporters to do anything beyond freezing their oil production, which might sorely disappoint oil bulls, said Amy Myers Jaffe, executive director of energy and sustainability for UC Davis.

"It was part of the reason why (OPEC) didn't want to make any hasty decisions," Jaffe said. "That changes a little bit the dynamic of the meeting. It gives everyone else a little more flexibility."

Part of Iran's problem is overseas buyers aren't lining up for Iran's oil yet. The Islamic Republic wants to enter contractual arrangements for steady sales volumes, which would increase Iran's market share in Europe, where it once dominated, rather than one-and-done spot-market sales.

"The pace and scale of Iran's recovery hinges on these term deal negotiations," said Matt Reed, vice president of Foreign Reports, a Washington, D.C.-based consulting firm focused on Mideast oil politics. "European refiners are weighing their options in a buyers' market."

It also appears European oil producers are hesitating to make many oil field investments in Iran, which Iran needs to help restart fields that have sat dormant for years. U.S. oil companies are still barred from doing business with Iran and others, analysts say, are likely afraid of the U.S. government's ability to throw its weight around in international trade.

Iran's 7-percent February production increase hasn't weighed heavily on the oil market because at the same time Iran was putting out more oil on the market, an Iraqi pipeline that feeds crude to a Turkish port was reportedly sabotaged, shutting off about as much of Iraq's oil production as Iran added. Two other OPEC nations, Nigeria and the United Arab Emirates, also experienced outages, and the group's overall output fell by 90,000 barrels a day last month, the IEA said in its monthly oil market report Friday.

Trades increasing

Leading member-nations in the Organization of Petroleum Exporting Countries, including Iraq, which has risen to OPEC's No. 2 spot, have long held they won't make room for Iran's return to the market by cutting their own production. But the outages have done that for them, at least in February.

The IEA says it is one reason the oil market may be seeing "a light at the end of what has been a long, dark tunnel," though it says the rebalancing process still has "a long way to go."

Another reason is it appears crude production outside of OPEC is falling faster than anticipated. The IEA estimates non-OPEC output will drop by 750,000 barrels a day this year, a better forecast than its last estimate of a 600,000 barrel-per-day decline, as low oil prices continue to pelt U.S. oil drillers. Shale crude production in several major U.S. plays is expected to drop by more than 100,000 barrels a day this month.

But rising crude prices - the U.S. benchmark has climbed nearly one-third higher than when the oil market rally began four weeks ago - could have its own consequences. Analysts say U.S. crude prices have entered a range that could spur oil-production hedging, which locks in higher prices for future harvests.

"The most recent body language and commentary that we've gotten from (producers) is that somewhere between $40 to $50, not only do you look at hedging but you also potentially look at bringing back drilling rigs and re-ramping activity," said Eli Kantor, an analyst at Iberia Bank in New Orleans. Some producers in lucrative West Texas fields would be able to send back rigs and increase their productions; others would keep their oil fields from declining as much, he said.

Oil companies set their annual budgets earlier this year when crude prices were firmly trading around $30 a barrel. But if they can get $45 or $50, they could generate the cash to bring rigs back into the field, Kantor said, and that could stem the decline in U.S. production that is supposed to rebalance the market. "Every day that crude goes up, there's definitely risk to that (predicted decline)," Kantor said.

The nation's active rig count fell by 9 to 480, the lowest level ever recorded by Baker Hughes in the nearly 70 years the company has tracked drilling activity.

Thomas Heath, a Houston executive at Asset Risk Management, which helps oil companies hedge their production, said in the past two weeks the number of trades has jumped from one or two per day to seven or eight. "It has gotten marginally more active," Heath said.

Fear of another glut

If speculators drive up prices in hopes of an OPEC production cut or other factors, they could end up squandering the environment that's forcing high-cost U.S. drillers to throttle back production.

Traders did that in the second quarter of 2015, when U.S. crude prices jumped from $43 to around $60 a barrel - enough to stimulate U.S. drilling activity and boost the nation's rig count. Instead of allowing the market to recover, they grew the world's oil glut.

"If this keeps going … my concern would be that U.S. production would not fall as much," Webster of IHS said. "And then all those concerns about storage become that much more acute and you will have this roll back down. If 2016 follows the 2015 pattern, then (oil prices) have the potential to go into the single digits next time around."

Energy reporter for the Houston Chronicle. Houston native. Former banking and finance reporter.

Prior to joining the Houston Chronicle, Collin Eaton covered the local banking and finance scene at the Houston Business Journal. Before that, he held internships at newspapers in Texas and Washington D.C., generally writing about business, money or higher education. He graduated from the University of Texas at Austin in 2011.